UNIT 3: ACCOUNTING FOR PLANT ASSETS AND DEPRECIATION

3.1: NATURE AND MEANING OF LONG-TERM ASSETS

Assets that can be used by a business enterprise for relatively long period (usually more than one
year) are called Long-Term Assets.
Assets.
Long-term assets are divided into tangible and intangible categories.
Tangible assets (also called plant assets or fixed assets) are assets with physical substance that
can be charged in the operations of business for a relatively longer period of time, usually more
than one year or one operating cycle whichever is longer. Examples are land, buildings,
equipments and machineries, trucks, etc.
In contrast, intangible assets are assets without a physical feature that can be charged in the
operations of business for long period of time. They generally consist of rights or advantages
held such as goodwill, patents, copyrights, franchise, trade marks, organization costs, etc.
3.2 DETERMINATION OF THE ACQUISITION COST OF PLANT ASSETS
The acquisition cost of plant (fixed) assets is the cash or cash-equivalent purchase price,
including incidental costs required to complete the purchase, to transport the asset, and to prepare
it for use.
For example, expenditures related to the acquisition of a plant asset such as freight, insurance
while in transit, and installation are included in the cost of the asset because they are necessary if
the asset is to function. According to the matching principle, therefore, such costs are allocated to
the economic life of the asset rather than charged as expenses in the current period.
Land
The acquisition cost of land includes the negotiated cash price plus other costs such as the cost of
land surveys, legal fees, title fees, brokers commissions, co9st of preparing the land to build on,
and even the demolition costs of old structures that might be torn down to get the land ready for
its intended use.
Under the historical cost assumption, land is reported in the balance sheet at its original cost.
Land is not subjected to depreciation because land does not have a limited useful life.
The following illustration will help us how to determine the cost of land.
Illustration-1
A business enterprise acquires a piece of land for future site. It pays a cash price of Br. 210,000,
pays brokerage fees of Br. 7500 and title fees of Br. 3000, pays Br. 5000 to have unwanted
building removed, and pays, Br. 1500 to have the site graded. The business receives

Br. 2000 salvage from the old building. The cost of the land is determined as follows:
Cash prices (negotiated price)Br. 210,000.00
Title Fees..3,000.00
Brokerage Fees...7,500.00
Cost of Grading..1,500.00
Cost of removing (demolition) unwanted building Br. 5000
Less: Salvage received.(2000)3,000.00
Total cost of land ..Br.
..Br. 225,000.00
Generally, land is part of property, plant and equipment. If the major purpose of acquiring and
holding land is speculative, it is more appropriately classified as an investment. If the land is held
on a real estate concern for resale, it should be classified as inventory. When the land has been
purchased for the purpose of constructing a building, all costs incurred up to the excavation for
the new building are considered land costs. Removal of old buildings clearing, grading and
filling are considered land costs because these costs are necessary to get the land in condition for
its intended purpose. Any proceeds obtained in the process of getting the land ready for its
intended use, such as salvage receipts on the demolition of an old building are treated as
reductions in the price of the land.
Cost of buildings
When an existing building is purchased its cost includes, the purchase price plus all repairs and
other expenses required to put it in a usable conditions. On the other hand, when a business
constructs a new building, the cost includes all reasonable and necessary expenditures, such as
those for materials, labor, part of the overhead and other indirect costs, engineers and architects
fees, insurance during construction, interest incurred on construction loans during the period of
construction, lawyers' fees, and building permits. If outside contractors are used in the
construction, the net contract price plus other expenditures necessary to put the building in
usable condition are included.
Cost of equipment
The term equipment in accounting includes office equipment, store equipment, factory
equipment, delivery equipment, machinery, furnitures and fixtures, and similar fixed assets. The
cost of such assets includes the invoice (purchase) price, transportation and handling charges,
insurance on the equipment while in transit, assembling and installation costs, and costs of

conducting trail runs. As indicated earlier, all costs of getting an asset ready for its intended use
are costs of that asset.
3.3 NATURE AND MEANING OF DEPRECIATION
As plant assets are used in the operations of a business, their value to provide service decreases
through usage and the passage of time.
This cost allocation of plant asset, called depreciation,
depreciation, is recorded in the accounting books
periodically.
Depreciation is frequently misunderstood. The term depreciation, as used in accounting, does not
refer to the physical deterioration of an asset or the decrease in market value of an asset
overtime.
Depreciation means the allocation of the cost of a plant asset to the periods that benefit from the
services of the asset.
The term depreciation is used to describe the gradual conversion of the cost of the asset into an
expense.
Depreciation is not a process of valuation.
valuation. Ac counting records are kept in accordance with the
cost principle; they are not indicators of changing price levels. It is possible that, through an
advantageous buy and specific market conditions the market value of a building may rise.
Nevertheless, depreciation must continue too be recorded because it is the result of an allocation,
not a valuation process.
3.4 FACTORS THAT AFFECT THE COMPUTATION OF DEPRECIATION
Four factors affect the computation of depreciation. They are:
(1) Cost
(2) Residual value
(3) Depreciable cost, and
(4) Estimated economic (useful) life.
Cost- is the net purchase price plus all reasonable and necessary expenditures to get the asset in
place and ready for use.
Residual value- also known as salvage value,
value, disposal value, scrape value, or trade-in value
represents the estimated market value of the asset at the time of its retirement.
Depreciable cost - represents the difference between the asset cost and its estimated residual
value. For example, an item of equipment that costs Br. 5000 and has a residual value of Br. 500

would have a depreciable cost of Br. 4500, (Br. 5000 - Br. 500). The depreciable costs must be
allocated over the estimated economic life of the asset.
Estimated economic (useful) life- the estimated economic life of an asset is the total number of
service units expected from the asset. Service units may be measured in terms of years the asset
is expected to be used, units expected to be produced, miles or kilometers expected to be driven,
or similar measures. In determining the estimated useful life of an asset, the accountant should
consider all relevant information, including (1) past experience with similar repair assets, (2) the
assets present condition, (3) the companys repairs and maintenance policy, (4) current
technological and industry trends, and (5) local conditions such as whether.
3.5 METHODS OF COMPUTING DEPRECIATION
Depreciation methods differ primarily in the amount of cost allocated to each period. A list of
depreciation amounts for each year of an assets useful life is called depreciation schedule.
schedule.
The most common methods of computing depreciation for plant assets are:
(1) The straight line method
(2) The units of production method
(3) The double-declining balance method, and
(4) The sum-of- the years-digits method.
3.5.1 Straight-Line Depreciation
When this method is used to allocate depreciation, the depreciable cost of the asset is spread
evenly (uniformly) over the useful life of an asset. The straight-line method is based on the
assumption that depreciation depends only on the passage of time. The depreciation expense for
each period is computed by dividing the depreciable cost by the number of accounting periods in
the assets estimated useful life. The depreciation expense to be reported is the same in each year.
The following illustration will help us to understand the Straight-Line method of computing
depreciation.
Illustration - 2
Suppose, for example a business enterprise acquires a new computer (office equipment) at a cost
of Birr 6000. It is estimated that the computer has an estimated residual value of Birr 1000 at the
end of its estimated useful life of 4 years. The yearly (annual) depreciation would be Birr 1250m
computed as follows:

Annual depreciation = Cost - Salvage value

Estimated useful life
= Birr 6000 Birr 1000 = Birr 1250
4 years
The depreciation to be reported for each of the four years would be as follows:
Depreciation Method- Straight-Line Method
Year

Cost

Yearly
Accumulated
Carrying value
Depreciation
Depreciation
(Book Value)
Beginning of first year
Br. 6000
Br. 6000.00
End of first year
6000
Br. 1250.00
Br. 1250.00
4750.00
End of second year
6000
1250.00
1250.00
3500.00
End of third year
6000
1250.00
3750.00
2250.00
End of fourth year
6000
1250.00
5000.00
1000.00
NB.
NB. There are three important points to note from the depreciation schedule for the straight-line
depreciation method. First, the depreciation is the same each year. Second, the accumulated
depreciation increases uniformly. Third, the carrying (Book) value decreases uniformly until it
reaches the estimated residual value.
4.6.2 Units of Production Method
The production method of depreciation is based on the assumption that depreciation is mainly the
result of use and that the passage of time plays no role in the depreciation process. If we assume
that the office equipment from the previous illustration has an estimated useful life of 10,000
hours, the depreciation cost per hour would be determined as follows:
Hourly depreciation = Cost Salvage value
Rate

= Br. 6000.00 1000 = Br. 0.50

Estimated units of useful life

10,000 operating hrs.

If we assume that the use of the equipment was 2800 hours for the first year, 3600 hours for the
second, 2400 hours for the third, and 1200 hours for the fourth, the depreciation schedule for the
office equipment would appear as follows:
Depreciation Schedule Production Method
Year
Beginning of the
First year
End of first year
End of second
year
End of third year
End of fourth year

Cost

Hours

Br. 6,000

Depreciatio
n Per Hour
Br. 0.50

Yearly
Depr.

Accum.
Depr.

6,000
6,000

2,800
3,600

0.50
0.50

Br. 1,400.00
1,800.00

Br. 1,400.00
3,200.00

4,600.00
2,800.00

6,000
6,000

2,400
1,200

0.50
0.50

1,200.00
600.00

4,400.00
5,000.00

1,600.00
1,000.00

Carrying value
(Book value)
Br. 6,000.00

Under the production method, there is a direct relation between the amounts of depreciation each
year and the units of output or use. Also, the accumulated depreciation increases each year
indirect relation to units of output or use. Finally, the carrying amount decreases each year in
direct relation to units of output or use until it reaches the estimated residual value.
Under the production method, the units of output or use that is used to measure estimated useful
fife for each asset should be appropriate for that asset. For example, for one machine number of
units produced may be an appropriate measure, for another number of hours may be a better
measure. The production method should be used only when the output of an asset over its useful
life can be estimated with reasonable accuracy.
4.6.3 Declining Balance Method
This method of depreciation results in relatively large amount of depreciation in the early years
of an assets life and smaller amounts in later years. This method is based on the assumption of
the passage of time. Since most kinds of plant assets are most efficient when new, and so they
provide more and better service in the early years of useful life. It is consistent with the matching
rule to allocate more depreciation to the early years than to later years if the benefits or services
received in the early years are greater.
The declining-balance method is the most common accelerated method of depreciation. Under
this method depreciation is computed by applying a fixed rate to the book value of the asset,
resulting in higher depreciation charges during the early years of the assets life. Though any
fixed rate might be used under the method, the most common rate is a percentage equal to twice
the straight-line percentage. When twice the straight-line rate is used, the method is usually
called the double-declining balance method.
method.
Referring to the previous example, the equipment had an estimated useful life of four years.
Consequently, under the straight-line method, the depreciation rate for each year was 25 percent,
(100/ estimated useful life of the asset for 100/ 4 years).
Therefore, under the double-declining balance method, the fixed rate is 50 percent (2X 25
percent). This fixed rate of 50 percent is applied to the remaining carrying value at the end of
each year. Estimated residual value is not taken into account in computing depreciation except in
the last year of an assets useful life, when depreciation is limited to the amount necessary to
bring the carrying value down to the estimated residual value. The depreciation schedule for this
method is as follows:

Depreciation Schedule, Double-Declining Balance Method

Year

Cost

Fixed Depr.
Rate

Yearly
Depreciation

Accumulate
Carrying Value
d
(BV)
Depreciation
Date of purchase
Br. 6000
50%
Br. 6000
End of first year
6000
50%
Br. 3000
Br. 3000
3000
End of Second year 6000
50%
1500
4500
1500
End of third year
6000
50%
750
5250
750
End of fourth year
6000
50%
250
550
500
NB.
NB. The fixed rate of 50% is always applied to the Book value at the end of the previous year.
The depreciation is greatest in the first year and declines each year after that. Finally, the
depreciation in the last year is limited to the amount necessary to reduce book value to residual
value, Br. 250 = Br. 750 Br. 500 (i.e. Previous book value minus residual value).
4.6.4 The Sum of The Years Digits Method
Like the declining balance method, the sum of the years digits method provides a higher amount
of periodic depreciation expense in the earlier use of the asset's life and a decline depreciation
expense thereafter because a successively smaller fraction is applied each year to the depreciable
cost of the asset. Under this method, first we must determine the denominator of the fraction,
which is the sum of the digits representing the years of life. While computing depreciation, the
denominator of the fraction is unchanged and would remain the same. On the other hand the
numerator of the fraction, decreases year by year (4/10,3/10/2/10/1/10). At the end of the assets
useful life, the balance remaining should be equal to the salvage value. For example, for a plant
asset with an estimated life of 4 years, the denominator of the fraction is 4+3+2+1 = 10. The
depreciation schedule for this method is as follows:
Depreciation Schedule- Sum - of - the - Years - Digits Method
Year

Depreciable
Rate
Yearly
Accumulated
Book Value
Cost
Depreciation
Depreciation
Date of purchase
Br6000
Br. 6000
End of first year
6000
4/10
Br. 2200
Br. 2200
3800
End of second year
6000
3/10
1650
3850
2150
End of third year
6000
2/10
1100
4950
1050
End of fourth year
6000
1/10
550
5500
500
NB.
NB. The above illustration for the sum of years digit method is based on the assumption that
the first use of the asset concide with the beginning of the fiscal period. When the first use of the
asset does not concide with the beginning of a fiscal year, it is necessary to allocate each full
years depreciation b/n the two fiscal years benefited. Assuming that the asset in the example was

placed in service after four months of the fiscal year had been elapsed, the depreciation for that
fiscal year would be Br. 1466.67 computed as follows:
First year depreciation = 4/10 X (6000 500) X 8/12. Br. 1466.67
Therefore, the depreciation for the second year would be

.Br. 1833.33

Computed as follows:
= 4/10 X (6000 500) X 4/12.. Br.

733.33

= 3/10 X (6000 500) X 8/12. 1100.00

Total, second fiscal year depreciation Br. 1833.33
3.8. REVISION OF DEPRECIATION RATES
When a plant asset is acquired, depreciation rates are carefully determined based on past
experience with similar assets and other relevant information. The provisions for depreciation are
only estimates, however, and it may be necessary to revise the estimated economic life and that
of salvage value during the life of the asset. Unexpected physical deterioration or unforeseen
obsolescence may make the useful life of the asset less than originally estimated. Good
maintenance procedures, revision of operating procedures, or similar improvements may prolong
the life of the asset beyond the original estimate.
Illustration - 5
Assume that a delivery truck originally acquired for Br. 75,000 is estimated to have a 16-year life
with a residual value of Br. 3000. However, after 10 years of intensive use, it is determined that
the delivery truck will last only 4 more years, (instead of 6 years) but its estimated residual value
at the end of the four years will be Br. 6000, (instead of Br. 3000).
Solution:
Before the revision of the estimated life and the residual value of the asset at the beginning of the
11th year, the asset ac count and its related accumulated depreciation account would appear as
shown below:
Delivery Trucks

Accumulated Depr- Delivery Truck

Cost 75,000
45,000 Balance at the
end of the 10th Year

After the revision, at the beginning of the 11th year, the remaining depreciable cost and the
revised annual depreciation by the straight-line method are computed as follows.
Original Cost of the truck.Birr 75,000
Less:
Less: Accumulated depreciation already taken 45,000
Remaining cost of the delivery truckBirr 30,000
Less:
Less: Revised estimated salvage value...6,000
value...6,000
Revised annual depreciation 30,000 - 6000
4 years

.Birr
.Birr 6,000

The new annual periodic depreciation expense is computed by dividing the revised depreciable
cost of Br. 24,000 by the remaining revised useful life of 4 years. Therefore, the new periodic
depreciation charge is Br. 6000. The annual adjusting entry for depreciation for the next two
years would be as follows:
Year 11
Dec. 31, Depreciation Expense - Delivery Truck..6000
Accumulated Depreciation - Delivery Truck6000
Year12
Dec. 31 Depr. Expense-Truck.6000
Accum. Depreciation-Truck60000
Depreciation of partial years
So far, the illustrations of the depreciation methods have assumed that the plant assets were
purchased at the beginning or end of the accounting period. However, business does not often
buy assets exactly at the beginning or end of the accounting period. In most cases, they acquire
the assets when they are needed and sell or discard them when they are no longer useful or
needed. The time of year is normally not a factor in the decision. Thus, it is often necessary to
calculate depreciation for partial years.
Illustration - 6
Assume that a piece of equipment is purchased for Br. 5000 and that it has an estimated useful
life of five years, and an estimated residual value of Br. 500. Assume further that the equipment
is purchased on October 2 and that the yearly accounting period ends on December 31.
Depreciation must be recorded for three months, October through December, or 3/12 of a year.
This factor is applied to the calculated depreciation for the entire year. The three months
depreciation under the straight-line method is calculated as follows:

Solution:
Annual depreciation = Original cost Estimated Salvage value
Estimated useful life
= Br. 5000 Br. 500 = Birr 900
5 years
Depreciation for partial year (Oct Dec. 31) is therefore, Br. 900 x 3/12 = Br. 225
If the company used the double declining balance method on the above equipment, the
depreciation on the asset would be: Br. 5000 x 40/100 x 3/12, = Br. 500, depr. For three months,
If the company used the sum-of-years-digits method, the depreciation on the asset would be:
Birr (5000 500) x 5/15 x 3/12 = Birr 375,
375, and the depreciation for the second year would be:
(5000 500) x 5/15 x 9/12 =

Br. 1125

(5000 500) x 4/15 x 3/12 =

300

Therefore, total 2nd year depreciation

Br. 1425

NB.
NB. In this specific example depreciation was recorded from the beginning of October. If the
equipment had been purchased on October 16, or thereafter, depreciation would be calculated
beginning November 1, as if the equipment were purchased on that date.
3.10 CAPITAL AND REVENUE EXPENDITURES
Capital ExpendituresExpenditures- are expenditures that improve the operating efficiency (or capacity) or
costs incurred to achieve greater future benefits.
In addition to the acquisition of plant assets, capital expenditures included additions and
betterments.
An addition is an enlargement to the physical layout of a plant asset. Suppose for example, if a
new wing is added to a building, the benefits from the expenditure will be received over several
years, and the amount paid for it should be debited to the asset account.
A betterment, on the other hand, is an improvement that does not add to the physical layout of
the asset. Installation of an air conditioning system is an example of betterment, Replacement of
a concrete floor for a wooden floor is also betterment that will provide benefits over a number of
years, so its cost should be charged (debited) to an asset account.
Another types of capital expenditures include extraordinary repairs.
repairs. Extraordinary repairs are
repairs of amore significant nature. They affect the estimated residual value or estimated useful
life of an asset. For example, a boiler for heating a building may be given a complete overhaul, at
a cost of Br. 3000 that will prolong its economic life by 5 years.

Extraordinary repairs are recorded by debiting the accumulated depreciation account, under the
assumption that some of the depreciation previously recorded has now been eliminated. The
effect of this reduction in the accumulated depreciation account is to increase the book value of
the asset by the cost of the extraordinary repair. As a result, the new book value of the asset
should be depreciated over the new estimated useful life.
Illustration - 7
Suppose for example, a machine costing Br. 35,000 had no estimated residual value and an
original estimated useful life of ten years, has been depreciated for 7 years. At the very beginning
of the 8th year, the machine was given a major overhaul costing Br. 3000. This expenditure
extended the useful life of the machine 3 years beyond the original estimate. The computation of
the new book value and the entry for the extraordinary repair would be as follows:
Solution
To record extraordinary repair
Jan. 4. Accumulated Depreciation Machinery3000.00
Cash 3000.00
Extraordinary repair to machinery
The revised annual depreciation for each of the six years remaining in the machines useful life
would be calculated as follows:
Cost of Machine
Accum. Depreciation before extraordinary repair
Less: extraordinary repair (Debited to Accum. Depr.).3000
Depr.).3000
Book value (carrying value) after extraordinary repair

Birr 35,000
Br. 24,500
21,500
Br.13,500

Revised Annual periodic depreciation= 13500.

2,250
13500.2,250
6 years
Revenue expenditures
Revenue expenditures are expenditures incurred in order to maintain the normal operating
efficiency of the asset.
Among the more usual kinds of revenue expenditures for plant asset are the repairs, maintenance,
lubrication, Cleaning and inspection necessary to keep an asset in good working condition.
Ordinary repairs are expenditures that are necessary to keep an asset in good operating
conditions. Trucks must have tune-ups, their tires and batteries must be replaced regularly, and
other routine repairs must be made. Offices and halls must be painted regularly, and broken tiles

or woodwork must be replaced. Such repairs benefits only the current period and therefore must
be charged against the revenue in the current fiscal period.